Conventional wisdom tells investors to buy and hold, and in the event of market crashes and bubbles, to ride it out and wait for things to turn around. Savvy investors, on the other hand, can learn to spot downturn indicators before a crash happens, which gives them time to move their money and potentially avoid large losses.
This is only possible for investors who understand market tops, corrections and crashes, their relationship with each other, and how to read market indicators based on historical facts. A relentless — and intentional — barrage of misinformation makes that a difficult task, but specific warning signs and red flags can telegraph trouble.
Stock Market Crashes
Stock market crashes are major events that can last anywhere from one day to four years, and are defined by losses of more than 20 percent. Characteristics involve public panic and rapid selloffs, which quickly and dramatically force stock prices to plummet, as they did in 1929,1987 and 2008, to name just a few.
When buy-and-hold investors are caught in crashes, they are often stuck waiting for a recovery that is a long way off. The largest, most destructive crashes are ugly, drawn-out affairs that can last for years.
Crashes often follow economic crises, global calamities or, in many cases, the collapse of a bubble which is, in investing, the “canary in the coal mine.” Even bubbles that don't trigger crashes can serve as a warning that a major correction is looming. Either way, the investor who can spot a bubble is in a stronger position.
Bubbles and Market Tops
Bubbles can form in economies, markets and individual securities. Bubbles form when a surge in price occurs that isn't backed by the fundamentals of the market, economy or security. Investors buy at an inflated price, presuming the rise will continue and that they'll be able to sell for a profit.
Eventually, the inflated price reaches its highest point—or market top —before the bubble bursts, or drops drastically, triggering a contraction. This drop could be just a mild correction — but it could also be a dangerous crash.
Bubbles can build for years. Smart investors and financial professionals can spot bubbles as many as five years before they finally burst, which eventually, they always do.
The onset of a bubble should tell investors and their advisors that the time has come to begin to use market top (sell high) tactics (link) that will help them have cash for when the eventual market bottom comes. With so much at risk, investors must know the red flags and warning signs that telegraph approaching bubbles and market tops.
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